Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Southwest Airlines Co. (NYSE:LUV) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Southwest Airlines Carry?

The chart below, which you can click on for greater detail, shows that Southwest Airlines had US$7.90b in debt in December 2023; about the same as the year before. However, its balance sheet shows it holds US$11.5b in cash, so it actually has US$3.57b net cash.

A Look At Southwest Airlines' Liabilities

Zooming in on the latest balance sheet data, we can see that Southwest Airlines had liabilities of US$12.3b due within 12 months and liabilities of US$13.7b due beyond that. Offsetting these obligations, it had cash of US$11.5b as well as receivables valued at US$1.14b due within 12 months. So its liabilities total US$13.4b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of US$20.2b, so it does suggest shareholders should keep an eye on Southwest Airlines' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Southwest Airlines also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the bad news is that Southwest Airlines has seen its EBIT plunge 18% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Southwest Airlines's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Southwest Airlines may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last two years, Southwest Airlines burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While Southwest Airlines does have more liabilities than liquid assets, it also has net cash of US$3.57b. Despite its cash we think that Southwest Airlines seems to struggle to convert EBIT to free cash flow, so we are wary of the stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Southwest Airlines (1 is potentially serious) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.